THE KIND OF INCENTIVES NEW ENERGY NEEDS TO GROW ON

Revealing the Hidden Value that the Federal Investment Tax Credit and Treasury Cash Grant Provide To Community Wind Projects
Mark Bolinger, January 2010 (Lawrence Berkeley National Laboratory)
and
PTC, ITC, or Cash Grant? An Analysis of the Choice Facing Renewable Power Projects in the United States
Mark Bolinger and Ryan Wiser, March 2009 (Lawrence Berkeley National Laboratory) and Karlynn Cory and Ted James, March 2009 (National Renewable Energy Laboratory)
and
Best Among Equals? Choosing Tax Incentives for Wind Projects
Budd Shaffer, David Rode, and Steve R. Dean, January 7, 2010, (Renewable Energy World)

SUMMARY
The New Energy industries are using this period of economic hesitation to study carefully the impacts of the various federal incentives that were in place before the dissipation of credit as well as those that have been put in place to compensate for the subsequent absence of credit. The intention is to not only come out of the recession ready to compete but to come out of it with a better understanding of which incentives will make them MORE competitive in this century’s budding New Energy economy.

As WHO BUYS SUN AND WHY detailed last week, the solar energy industry is nearing an inflection point in its growth where it must begin appealing to a bigger segment of the public. The careful look it is taking at its rebates, performance based, and financing incentives is giving solar professionals the opportunity to better understand what will create that bigger cohort of buyers.

Wind's assessment of incentives presents more complicated questions.

The federal incentives that have throughout this century had the most important impact on the New Energy industries have been tax credits. In late 2008 and early 2009, as the economy crumbled, credit froze and banks teetered on the brink of failure, astute leaders in New Energy quickly saw tax equity would lose its appeal. They successfully steered a sympathetic Obama administration to a set of variations on tax credits.

The solar industry is trying to figure out what kind of incentives will get more people to buy rooftop systems. (click to enlarge)

Those variations have now been in place long enough for researchers at the U.S. Department of Energy’s laboratories to analyze impacts. The conclusion: The kind of federal incentive that best serves New Energy depends on the size of the New Energy project and where it is.

Until the October 2008 financial rescue, there were 2 primary tax credits. With the Production Tax Credit (PTC), a project earned a tax discount for every unit of energy the project produced. With the Investment Tax Credit (ITC), a system purchaser got a percentage of the cost of the system discounted from federal taxes.

There were 2 variations on these tax credits put in place in response to the economic collapse of late 2008 were:
(1) The option to take the ITC with 3 important improvements, (a) it was put in place for a longer period of time (8 years), (b) it was provided to more kinds of New Energy and (c) it covered 30% of the full value of the project instead of only the first part of the project’s cost; or
(2) The option to take an upfront cash grant for the value of a part (30%) of the project’s cost.

For wind, the choices are complicated. (click to enlarge)

As the authors of Best Among Equals? Choosing Tax Incentives for Wind Projects demonstrate, for big wind projects that promise to produce big quantities of electricity, the PTC is still the best choice, though in a capital-constrained economy it may not be an available choice.

For small wind systems, usually purchased by homeowners and small business owners, the ITC is a more preferable option because it is like a discount on the price.

For medium-sized wind projects – termed community wind because they are small enough to be largely locally owned but big enough for their output to be described as utility-scale – the best incentive, as Mark Bolinger demonstrates in Revealing the Hidden Value that the Federal Investment Tax Credit and Treasury Cash Grant Provide To Community Wind Projects, is probably the cash grant, with a set of ancillary benefits like relief from the alternative minimum tax and passive credit limitations.

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COMMENTARY
Definitions:

Small Wind: Turbines or systems with a capacity of less than 100 kilowatts, usually installed by homeowners and small business owners to beat the price of retail electricity, they represent a fast-growing segment of the wind industry.

Community Wind: Locally owned wind projects of utility-scale grid-connected turbines (bigger than 100 kW) in which one or more members of the local community have a significant and direct financial stake. Such wind projects were common in the U.S. in the past and are still common in Europe (Denmark,Germany) but have remained only ~2% of U.S. installed wind capacity over the last half-decade.

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The growth of big wind projects staggered in the wake of the economic downturn. The usefulness of tax equity to profitable big money investors turned to uselessness when any profits they might have had, and the tax burden that would have come with them, disappeared.

The growth of small wind hesitated as consumers restrained their spending. This ironically opened up opportunity for shovel-ready community wind. Financing was already in place for projects that had before then been waiting for scarce boom-time resources (turbines, cranes, contractors, supply chain nuts and bolts) to become available.

Why is the new ITC the best incentive choice for ncommunity wind? A hypothetical 10.5 megawatt community wind project in the LBNL study benefits by roughly $40 per megawatt-hour from electing the 30% cash grant over the PTC. Only about $15 per megawatt-hour of that benefit is attributable to the 30% cash grant’s incremental face value over the PTC. The other $25 per megawatt-hour comes fro other ancillary benefits.

Ancillary Benefits: (1) Full relief from the alternative minimum tax; (2) No “haircuts” for certain government grants or subsidized energy financing; (3) Relief from the passive credit limitations and at-risk rules (30% cash grant only); (4) No power sales requirement (enables behind-the-meter projects to qualify); (5) No owner/operator requirement (enables leasing as a viable financing structure); (6) Less performance risk (because the ITC/grant do not depend on production); and (7) Greater ease in qualifying for exemptions from SEC regulations surrounding securities registration (30% cash grant only).

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A thriving, even if small, community wind sector offers special advantages, according to the LBNL paper. Local ownership and greater use of local contractors leads to more local economic development than larger scale projects. This generates more public acceptance for wind, which is of vital importance for an industry with ongoing siting and permitting challenges. Community wind also creates a broader investor base and leads to a heretofore largely untapped pool of investor capital, a potentially invaluable opportunity with tax equity investors still retiring due to the financial crisis.

Like the dominant parts of the industry, which adjusted to new financing opportunities and began growing again, community wind realized the importance of the 30% cash grant for passive investors in community wind projects and is likely to seek its extension.

70% of wind projects expected through 2012 should, by the precise statistical analysis from Wiser, Bolinger, Cory and James (as described by Shaffer, Rode and Dean) favor the existing PTC, not the 30% ITC/cash grant. But in a financially-constrained environment, the ITC/cash grant may be the only feasible choice even though it could cost the wind industry as much as $2 billion in potential value by 2012.

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The Bolinger, Wiser, Cory and James LBNL/NREL study on incentives created a set of charts composed of the full range of project sizes and costs. It established the statistically best choice of incentives for each combination to maximize investor return. When scarce capital forces the developer to choose an incentive that is not the investor’s best choice, money is left on the table.

No other factor is more predominant in the choice of incentives than location. Project conditions (the factors that determine size and cost and that therefore determine the preferential incentive) vary by terrain, transportation costs, required permits and labor costs. Capacity factors vary by wind resources. These all begin with the project's location.

The NREL/LBNL researchers divided the country into 9 regions. They then recalibrated the average capacity factor and installed cost for each region to better define the best incentive choice.

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Most regions favor the PTC. In some regions, the capacity factor and/or installed cost can vary by 30% and still not alter the preferred incentive. In others, small deviations from the average values change the incentive preference.

The optimal tax credit in the Texas and Eastern regions varies with small fluctuations in project cost, capacity factor and discount rate. If a project has an installed cost of $1,900 and a capacity factor of 34%, the ITC is preferred for discount rates above 10% and the PTC is preferred for discount rates below 10%. In a similar manner, any of the 3 variables can be evaluated independently to quantify their influence on the tax credit decision.

This leaves one important question for wind industry leaders who want to continue guiding the fate of wind power by influencing decision-makers about how to design incentives: Which regions are projected to see the majority of wind installations?

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U.S. Energy Information Administration (EIA) projections were revised after the Recovery Act began to shift energy sector supply and demand factors. An example of how ARRA changed activity in the wind industry: April EIA projections were for 2.29 more gigawatts of 2010 wind installations in New England (North American Electric Reliability Council, NERC, Region 7) than March projections.

The projected number of near future installations is expected to increase similarly for most regions, thanks to more viable incentives in ARRA. New England, California and the Northwest are likely to have substantial increases.

From such numbers, the overall impact of ARRA begins to clarify. Conclusion: 30% of total new wind capacity expected through 2012 is likely to come in NERC regions that favor the ITC (because ARRA upped the viability of the ITC). Since ~36.3 gigawatts of wind will likely be built in NERC regions through 2012, ~10.9 gigawatts will use the ITC and ~25.4 gigawatts will favor the PTC.

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Factors other than tax credits can, of course, influence a wind project developer’s financing decisions. In current circumstances, the most important is the dearth of investors who want tax equity. The result is that more projects turn to the ITC cash grant than would be expected from a purely statistical analysis.

Other factors that could skew a developer’s choice of incentives: (1) concern over performance risk, (2) project salability, (3) subsidized energy financing, (4) power sale requirements, and (5) owner/operator requirements.

The best guess from Shaffer, Rode and Dean is that project salability most clearly favors the PTC while the other 4 considerations tend a developer toward the ITC.

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Reasoning along these lines is what led to the conclusion that if all installations through 2012 select the ITC rather than the PTC, the wind industry would essentially be leaving ~$2 billion of available incentives unused.

If this is true, Shaffer, Rode and Dean say, developers will not leave that money unused but will evolve financing structures to once again attract tax equity investors.

An example from NERC’s Heartland region: By choosing the ARRA-revised ITC over the PTC, developers would forego on average $157 per kilowatt. It is reasonable to assume a developer would give up part of that $157 per kilowatt (to “share the wealth”) to entice a tax equity investor.

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On the other hand, it is possible development will shift to NERC regions that favor the ITC if it continues to be impossible, despite “share the wealth” strategies, to win tax equity investors back into wind investments.

This shift could move development from where the wind is richest (like the Midwest) to where power pays the most (like the Northeast). High installation costs in the Northeast would not be detrimental but would get more ITC/cash grant money up front. Also, the higher cost of production would be offset by the higher return from much higher power prices.

Bottom line: There may be interesting and unexpected consequences from the ARRA incentives introduced to keep the New Energy industries growing during the recession. There could be more development where wind is weaker and power costs more instead of where wind is more powerful and more plentiful.

Whatever emerges, more knowledge about the best way to write policy to drive New Energy will come along with it.

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QUOTES
- From PTC, ITC, or Cash Grant? An Analysis of the Choice Facing Renewable Power Projects in the United States by Bolinger, Wiser, Cory and James: “Over the full range of [wind] project costs and capacity factors presented, the PTC provides more value than the ITC in about two-thirds of all cases analyzed…Intuitively, projects with higher capacity factors and lower installed costs favor the PTC over the ITC (i.e., a higher capacity factor means that more PTCs are generated, while lower installed costs mean that the value of those PTCs will add up to a higher percentage of installed costs)…Because the 30% ITC applies to only 75% of installed [geothermal project] costs, the PTC provides more value in nearly all cost and capacity factor combinations examined. The PTC’s superiority becomes unanimous under a 5% discount rate…but falls to about 90% of all cases examined under a 10% discount rate…”

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- From PTC, ITC, or Cash Grant? An Analysis of the Choice Facing Renewable Power Projects in the United States by Bolinger, Wiser, Cory and James: “Although the relative financial value of each credit…is no doubt one of the most important considerations in choosing between the PTC and the ITC (or equivalent cash grant), it is by no means the only factor. A number of other, more-qualitative considerations might also play important roles in driving the decision, particularly when the quantitative difference is modest. These include…Option to Elect Equivalent Cash Grant… Performance Risk… Tax Credit Appetite… Liquidity… Subsidized Energy Financing… Power Sale Requirement… Owner/Operator Requirement…”

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- From PTC, ITC, or Cash Grant? An Analysis of the Choice Facing Renewable Power Projects in the United States by Bolinger, Wiser, Cory and James: “…only two of the five technologies modeled clearly favor one credit over the other: open-loop biomass receives more value from the ITC in every combination of installed cost and capacity factor modeled, while geothermal overwhelmingly receives more value from the PTC (regardless of whether the ITC equals 10% or 30%). The other three technologies – wind, closed-loop biomass, and landfill gas – are more evenly split between the two credits, though with a slight preference for the PTC…If, however, one subscribes to the view that most projects are likely to fall towards the middle of the installed cost and capacity factor ranges modeled rather than at the extremes… the difference between the PTC and ITC for these three technologies is likely to be rather modest…As such, qualitative considerations may play as much or more of a role in driving the choice of PTC or ITC (or equivalent cash grant)… Moreover, project developers and investors may place considerably more emphasis on qualitative rather than quantitative considerations (or vice versa), or may weigh certain qualitative considerations more heavily than others. Whatever the outcome, the mere fact that this choice of federal incentives now exists (albeit temporarily) is undoubtedly a positive development for renewable project finance in the United States, as it enables each project to choose the incentive that best fits its needs.”